According to the FRB/US model, the current expected path of raising interest rates (co-275bp) may cause the US economy to enter a recession in the second quarter of 2023. Aggressive interest rate hikes will prolong the recession, and neutral or moderate interest rate hikes may avoid recession, but high oil and gas prices increase the additional recession risk. Historically, the Fed has stopped raising interest rates after the reversal of the US debt 10Y*3M. The Fed stopped raising interest rates this year and then began to cut interest rates is a safe choice to avoid a recession. The current overly aggressive rate hike is expected to face a correction in the future.

Futures markets now show that the Fed will raise interest rates by 250 basis points by early February. Never since 1994 has the Fed taken such a big tightening measure in a year: raising interest rates by 250 basis points a year.

The last time interest rates were raised more aggressively was when Volcker was at the helm of the Federal Reserve in the early 1980s. Will the Fed's aggressive austerity actions push the US economy into recession?

The restraining effect of interest rate hikes on the economy is mainly through four aspects:

1) for enterprises, raising interest rates raises the cost of debt, which reduces profits, which in turn affects the capital expenditure of enterprises.

2) for residents, the interest rate increase increases the interest cost of residents, especially the credit consumption of durable goods mainly for cars and the loan repayment cost of real estate.

3) for government departments, the increase in interest rates has raised the debt cost of government departments, the government is trapped in the debt ceiling, and fiscal expenditure has weakened.

4) for the financial market, the increase in interest rate tightens the liquidity of the financial market, the stock falls, the credit spread expands, the consumption of residents weakens under the wealth effect, and the financing difficulty of enterprises increases.

First, using the FRB/US model to quantitatively measure the economic impact of interest rate increases.

According to the estimates of the FRB/US model released in 2018, an one-off increase in interest rates by 100bp will reduce GDP growth by 0.48% and increase the unemployment rate by 0.2%, with the greatest impact occurring one to two years after the interest rate increase. The 10-year yield on Treasuries rose 30bp, but the impact was mainly three quarters after the rate hike.

FRB/US model is the main forecasting model of the Federal Reserve, which has been used by the Federal Reserve since 1996.

We use the FRB/US model to quantify the Fed's follow-up policy path and make two basic settings: (1) participants in the economy follow imperfect rational expectations; (2) the federal funds rate is an independent variable.

Suppose the path of raising interest rates is as follows: path 1, as a reference group, simulates the expectation of raising interest rates in the current market, starting from the first quarter of 2022, raising interest rates according to the rhythm of 25+100+50+50+50bp, accumulating interest rate increases 275bp.

Paths 2, 3, 4 and 5 assume that the Fed raises interest rates moderately, moderately, neutrally and aggressively, respectively, by raising interest rates 100bp, 175bp, 200bp and 325bp respectively, as shown in the chart below.

The following three diagrams are the shock response functions of the five interest rate increases simulated by the FRB/US model to the output gap (XGDP2), unemployment rate (LUR) and real GDP growth. The output gap here is defined as:

Taking the benchmark interest rate hike hypothesis (path 1) as an example, the biggest impact on the simulated output gap and unemployment rate is-1.19% and 0.67%, respectively.

If we extrapolate linearly according to the results of the 2018 FRB/US model, the maximum impact of cumulative 275bp interest rate increases on the output gap and unemployment is-1.34% and 0.60% (multiplied by 2.75 times).

From this point of view, the impact of interest rate hikes will not increase nonlinearly with the doubling of cumulative interest rate increases. Compared with the benchmark interest rate hike hypothesis, the aggressive interest rate hike hypothesis (path 5) raised interest rates more sharply in the early stage, so it had a greater impact on unemployment and economic growth, and the biggest shock occurred roughly one quarter earlier.

Second, the maximum rate of interest increase that the economy can afford.

At present,The Atlanta Fed GDP Now forecasts a 1.1% annualized rate for the Q1 quarter adjustment in 2022.According to the modelAs a result of the benchmark path interest rate hike 275bp, the 23-year Q2 US economy is likely to fall into recession.

If interest rates are raised aggressively, the recession will last longer. If interest rates are raised neutrally or moderately, GDP will fall by up to 0.6%, which may avoid a recession, butHigh oil and gas prices and shrinking tables add to the additional risk of recession.

Consider the impact of oil prices.Over the past 50 years, when oil prices (equivalent to today's purchasing power) exceed $70 a barrel, the US economy has a high probability of recession; when (12-month moving average) oil prices grow by more than 50%, the probability of recession is 100%. Now both conditions (oil price 70 cents, a growth rate of 50% +) have been met. For every $20 per barrel increase in oil prices above $70, real GDP growth fell by 0.94 per cent.

Then consider the impact of shrinking the table.Assuming the Fed shrinks its balance sheet by about $9 trillion a month from May, we estimate that the 10-year maturity premium will rise by about 17bp this year, equivalent to an additional 1.4 interest rate hikes.

Considering only raising interest rates, a 275bp hike could push the US economy into recession, with GDP falling by 1 per cent in the second quarter of 2023.Taking into account the increase in the maturity premium of the shrinking table, 200bp can enter a recession by raising interest rates, that is, GDP will fall by 0.7%.The recession is ahead of schedule.

III. Time to stop raising interest rates-- after 3M-10Y US debt interest rates were upside down

We focus on the spread between the long and short end of US debt.This spread needs to be kept positive before the Fed can continue its interest rate policy.At present, 10-year and 2-year yields have been briefly inverted, but there is still 198bp in the 3-month and 10-year curve. The core reason is that the 2-year interest rate has risen to 2.5%, which contains inflation expectations upside down with 10-year inflation expectations, and it fully takes into account the Fed's expectations of raising interest rates in the next 1-2 years, so the gap with the benchmark interest rate is much higher than normal.

Because the three-month and 10-year upside-down is closer to the recession, and the current spread is more in line with the state in which the Fed has just raised interest rates, we choose the 10-year and three-month spreads as the object of study.

Historically, the probability of a recession after five 10-year and three-month periods since 1985 is 60%.After hanging upside down, the Fed stopped raising interest rates.

Among them, the upside-down in 1998 was because the global risk aversion triggered by the Asian financial crisis depressed long-term interest rates, and the Fed cut interest rates only 18 days after the upside-down, so there was no substantial recession. The upside-down in 2019 was due to a slowdown in the economy caused by successive interest rate increases by the Fed, and long-end interest rates stagnated, but the Fed quickly cut interest rates three times after hanging upside down for four months, also avoiding a recession (the recession was directly hit by the epidemic in 2020). The duration of both upside down is within five months.

The other three upside down (1988, 2000, 2006), except for the 1988 cycle, the time of interest rate cut lagged slightly (1-6-14), the duration of the upside down varied from 6 to 12 months, and the economy also fell into recession.

You can seeAfter the 10Y*3M upside down, the Fed quickly cut interest rates and quickly got out of the upside-down state is an effective way to avoid recession.

With reference to the Fed's aggressive 275bp interest rate hike plan, the three-month Treasury yield is expected to be between 2.33% and 2.58% by the end of the year.

The impact of the FRB/US model shows that the interest rates on long-end US bonds will rise 32bp in 3 quarters after the interest rate increase, and the yields on 10-year US Treasuries and 3-month US Treasuries will be inverted by about 2.5%.

According to the law of history, the Fed will not raise interest rates after the 10Y*3M is upside down, which means that the Fed needs to do so before the three months and 10 years are upside down.That is to say, if Q4 stops raising interest rates this year, the safer choice is to start cutting interest rates immediately after hanging upside down, in order to avoid a recession.It also means that the current overly aggressive interest rate hike is expected to face a correction in the future.

It is a daunting task for the Fed to avoid a recession while controlling inflation.

According to the historical pattern of past interest rate raising cycles, the Fed generally stopped raising interest rates about a year or more before the recession began. So even according to the benchmark model of raising interest rates, the Fed needs to stop raising interest rates in the second half of this year at the latest.

Risk Tips:Us inflation exceeded expectations, Fed monetary policy tightened more than expected, and US fiscal tightening exceeded expectations.